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OFFICE DEPOT INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) RESULTS OF OPERATIONS OVERVIEW Office Depot, Inc., together with its subsidiaries ("Office Depot" or the "Company"), is a global supplier of office products and services to consumers and businesses of all sizes. On November 5, 2013, we merged with OfficeMax Incorporated ("OfficeMax") (the "Merger"). We sell to customers throughout North America, Europe, and Asia/Pacific through three reportable segments (or "Divisions"): North American Retail Division, North American Business Solutions Division and International Division. The North American Retail Division includes our retail stores in the United States, including Puerto Rico and the U.S. Virgin Islands, which offer office supplies, technology products and solutions, business machines and related supplies, facilities products, and office furniture. Most stores also have a copy and print center offering printing, reproduction, mailing and shipping services. The North American Business Solutions Division sells office supply products and services in Canada and the United States, including Puerto Rico and the U.S. Virgin Islands. North American Business Solutions Division customers are served through dedicated sales forces, catalogs, telesales, and electronically through our Internet sites. Our International Division sells office products and services through direct mail catalogs, contract sales forces, Internet sites, and retail stores in Europe, and Asia/Pacific. Following the date of the Merger, (i) the former OfficeMax U.S. Retail business is included in the North American Retail Division; (ii) the former OfficeMax U.S. contract and Canadian businesses ("Grand & Toy") are included in the North American Business Solutions Division; and (iii) the former OfficeMax business in Australia and New Zealand is included in the International Division. The former OfficeMax business in Mexico is presented as an Other segment. The integration of this business, into the International Division was suspended in the second quarter of 2014 due to the sale and it was managed and reported independently of the Company's other international businesses, through the date of the sale. Prior period segment information has been recast to reflect this change in reporting structure. During the fourth quarter of 2013, we modified the measure of business segment operating results for management reporting purposes to exclude from the determination of Division operating income (loss) the impacts of asset impairments, Merger and integration, restructuring, and certain other charges and credits. These activities now are being managed at the Corporate level. The change was intended to present these activities apart from the expenses incurred to sell to and service our customers. Refer to Note 12 of the Condensed Consolidated Financial Statements for additional segment information. Also, to be consistent with how the business is managed, starting in the fourth quarter of 2013, the Company began presenting a single financial statement line item titled Selling, general and administrative expenses which includes the amounts that were previously reported in Operating and selling expenses and General and administrative expenses. Neither the change in Division operating income (loss) nor Statement of Operations presentation had an impact on Consolidated Operating income (loss), Net income (loss), or Earnings (loss) per share for the prior periods presented. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide information to assist readers in better understanding and evaluating our financial condition and results of operations. We recommend reading this MD&A in conjunction with our Condensed Consolidated Financial Statements and the Notes to those statements included in Item 1 of this Quarterly Report on Form 10-Q, as well as our 2013 Annual Report on Form 10-K, filed with the U.S. Securities and Exchange Commission (the "SEC") on February 25, 2014 (the "2013 Form 10-K"). This MD&A contains significant amounts of forward-looking information. Without limitation, when we use the words "believe," "estimate," "plan," "expect," "intend," "anticipate," "continue," "may," "project," "probably," "should," "could," "will" and similar expressions in this Quarterly Report on Form 10-Q, we are identifying forward-looking statements (as such term is defined in the Private Securities Litigation Reform Act of 1995). Our discussion of Risk Factors, found in Item 1A of our 2013 Form 10-K and in Item 1A of this Quarterly Report, and Forward-Looking Statements, found in Item 1A of our 2013 Form 10-K, apply to these forward-looking statements. 24-------------------------------------------------------------------------------- Table of Contents A summary of certain factors impacting results for the 13-week and 39-week periods ended September 27, 2014 (also referred to as "the third quarter of 2014" and "year-to-date 2014") and September 28, 2013 (also referred to as "the third quarter of 2013" and "year-to-date 2013") is provided below. Additional discussion of the 2014 third quarter and year-to-date results is provided in the narrative that follows this overview. Merger • The Merger was completed on November 5, 2013. Accordingly, the Condensed Consolidated Statement of Operations for the third quarter and year-to-date 2014 include the OfficeMax results, affecting comparability of 2014 and 2013 amounts. Due to the significance of the OfficeMax results to the Company, the consolidation of OfficeMax sales and operating expense categories in 2014, as well as the Merger-related integration and restructuring activities, are the main drivers of the changes in results of operations when compared to the 2013 results. • The impact of the Merger on total Company sales is as follows: Third Quarter 2014 Third Quarter 2013 % Change Contribution Total from Total Total Excluding Company OfficeMax Company Company OfficeMax (In millions) Sales Banner Sales Sales ContributionNorth American Retail Division $ 1,722 $ 663 $ 1,128 53 % (6 )% North American Business Solutions Division 1,522 686 811 88 % 3 % International Division 797 127 680 17 % (1 )% Other 28 28 - - % - % Total $ 4,069 $ 1,504 $ 2,619 55 % (2 )% Year-to-Date 2014 Year-to-Date 2013 % Change Contribution Total from Total Total Excluding Company OfficeMax Company Company OfficeMax (In millions) Sales Banner Sales Sales Contribution North American Retail Division $ 4,989 $ 1,935 $ 3,211 55 % (5 )% North American Business Solutions Division 4,554 2,128 2,408 89 % 1 % International Division 2,565 420 2,137 20 % - % Other 155 155 - - % - % Total $ 12,263 $ 4,638 $ 7,756 58 % (2 )% • Due to the similarities in the underlying businesses under both banners (Office Depot and OfficeMax), the trends impacting the results are often the same or similar. In the Division operating results discussion that follows, where the factors affecting the Office Depot business differ significantly from the factors affecting the OfficeMax business compared to their operations in the 2013 periods presented (before the Merger), separate explanations will be provided. As the integration of the two companies' systems, processes and offerings continues, the delineation of the contribution from the separate companies is diminishing; however, it remains relevant for the third quarter of 2014. • In August 2014, we completed the sale of our interest in Grupo OfficeMax S. de R.L. de C.V. and related entities (together, "Grupo OfficeMax") to our joint venture partner, for net cash proceeds of $43 million. The loss associated with this disposed Mexican business amounted to approximately $2 million, which resulted primarily from the release of the net foreign currency remeasurement differences from investment to the disposition date recorded in other comprehensive income (cumulative translation adjustment) and fees incurred to complete the transaction. 25 -------------------------------------------------------------------------------- Table of Contents Other Significant Factors Impacting Total Company Results and Liquidity • Total Company Selling, general and administrative expenses increased in 2014 compared to 2013, reflecting the addition of OfficeMax operating expenses in 2014. Total Company Selling, general and administrative expenses as a percentage of sales decreased, reflecting lower advertising expenses, as well as operational efficiencies. • Non-cash asset impairment charges of $6 million and $49 million were recorded in the third quarters of 2014 and 2013, respectively. In year-to-date 2014 and 2013, non-cash asset impairment charges of $77 million and $58 million were recorded, respectively. The 2014 year-to-date charges include a $28 million asset impairment related to the abandonment of a software implementation project in Europe, $26 million related to the write off of capitalized software following certain information technology platform decisions related to the Merger, as well as store impairments. The third quarter and year-to-date 2013 impairment charge includes a $44 million goodwill impairment triggered by the sale of our interest in Office Depot de Mexico S.A. de C.V. ("Office Depot de Mexico"). Both periods in 2014 and 2013 include charges related to underperforming stores in North America. • We recorded an $81 million incremental increase to the legal accrual during 2014 based on a potential settlement in the amount of $68 million relating to allegations regarding certain pricing practices under now expired agreements that were in place between 2001 and January 1, 2011. The accrual also covers attorney's fees and other related legal matters. • We recognized $72 million and $276 million of Merger, restructuring, and other operating expenses, net in the third quarter and year-to-date 2014, respectively. In the third quarter of 2014, this line item includes $55 million of expenses related to Merger integration activities and $17 million of restructuring and other operating expenses. In year-to-date 2014, this line item includes $242 million of expenses related to the Merger transaction and integration activities, including store closure costs incurred to date, and $34 million of restructuring and other operating expenses. We estimate that merger and integration expenses will be $400 million during the three-year period of 2014 through 2016, excluding costs related to rationalizing and optimizing the U.S. retail store base and other asset impairments. We anticipate that approximately $300 million of these integration expenses will be incurred in 2014. In addition, for all store closures in 2014, we expect to accrue approximately $40 million for any remaining lease obligations, subject to mitigation through negotiations with landlords and in some cases subleasing, and additional other store closure costs. • Interest income increased in 2014 primarily due to the impact of OfficeMax Timber Notes income. Interest expense in 2014 increased in 2014 when compared to 2013, mainly due to interest expense related to OfficeMax recourse and non-recourse debt, which was partially offset by the maturity of $150 million of the 6.25% senior notes in August 2013. • The effective tax rates for the third quarter and year-to-date 2014 of 6% and -2%, respectively, reflect the impact of valuation allowances limiting recognition of deferred tax assets. Because of the valuation allowances and changes in the mix of earnings among jurisdictions and during interim periods, the Company continues to experience significant effective tax rate volatility within the year and across years. • Earnings per share were $0.05 in the third quarter of 2014 compared to diluted earnings per share of $0.41 in the third quarter of 2013. Loss per share was $(0.51) in year-to-date 2014 compared to an earnings per share of $0.18 in year-to-date 2013. The weighted average shares used for the 2014 EPS calculations include the impact of shares issued in the fourth quarter of 2013 in connection with the Merger. The 2013 EPS was positively impacted by the gain on joint venture sale. • At September 27, 2014, we had $965 million in cash and cash equivalents and $1.2 billion available under the Amended Credit Agreement. Cash flow generated by operating activities was $35 million for the year-to-date 2014. 26 -------------------------------------------------------------------------------- Table of Contents OPERATING RESULTS Discussion of Corporate and Other items, including material charges and credits and changes in interest and income taxes, follows our review of segment results. NORTH AMERICAN RETAIL DIVISION Third Quarter Year-to-Date (In millions) 2014 2013 2014 2013 Sales $ 1,722 $ 1,128 $ 4,989 $ 3,211 % change 53 % (4 )% 55 % (5 )% Division operating income $ 79 $ 15 $ 110 $ 16 % of sales 5 % 1 % 2 % - % Comparable store sales decline (3 )% (2 )% (3 )% (4 )% Sales in our North American Retail Division increased 53% in the third quarter of 2014 compared to sales in the same period last year, primarily as a result of the addition of OfficeMax 2014 sales of $663 million. Excluding the OfficeMax sales, 2014 sales would have decreased 6%. Comparable store sales in 2014 from the 1,050 stores under the Office Depot banner that were open for more than one year decreased 3% in the third quarter of 2014. For the Office Depot banner, average order value remained flat and transactions declined, reflecting lower customer traffic. Sales of ink and toner, portable computers, and computer related products declined, while sales of supplies, furniture, and in Office Depot Copy and Print Depot increased. Our comparable store sales relate to stores that have been open for at least one year. Stores are removed from the comparable sales calculation during remodeling and if significantly downsized. Our measure of comparable store sales has been applied consistently across periods, but may differ from similar measures used by other companies. As the Company refines its real estate strategy and the integration of Office Depot and OfficeMax stores progresses, comparable store sales may be impacted as customers migrate from closed to nearby stores which remain open. In addition to comparable sales trends discussed above, total sales were impacted by store closures. The Company believes that some shoppers continue to purchase in Company stores that are in proximity to closed locations and online or through catalogs. Online and catalog sales are reported in the North American Business Solutions Division. While store closures result in lower sales in the North American Retail Division, they are typically lower performing stores and future Division operating income may benefit. The North American Retail Division reported operating income of $79 million in the third quarter of 2014, compared to $15 million in the same period of prior year. The Division's operating income improvement in the third quarter of 2014 reflects higher gross profit margin from the addition of the OfficeMax banner and improvements in the Office Depot banner, as well as synergy benefits from combining the two companies. As the integration of the businesses continues, including the phasing in of certain common systems, the identity of revenues and expenses will not be as clear at the individual banner level and operating trends will be discussed at the Division level for the remainder of 2014. In year-to-date 2014, sales in our North American Retail Division increased 55% compared to sales in the same period last year, primarily as a result of the addition of OfficeMax 2014 sales of $1,935 million. Excluding the OfficeMax sales, 2014 sales would have decreased 5%. The factors discussed impacting the third quarter of 2014 sales and Division operating income are also reflective of those impacting year-to-date. During the third quarter of 2014, the North American Retail Division opened one store and closed 20, ending the period with a store count of 1,851. For year-to-date 2014, the North American Retail Division opened two stores and closed 63. Based on the current real estate strategy, at least 400 stores in North America are expected to be closed over the next three years, with approximately 165 stores closing in 2014, including those closed through the end of the third quarter. The more than 400 store closures are expected to result in at least $100 million in annual run-rate synergies and will be accretive in 2015. In addition, for all store closures in 2014, we expect to accrue approximately $40 million for any remaining lease obligations, subject to mitigation through negotiations with landlords and in some cases subleasing, and additional other store closure costs. The real estate portfolio optimization plan will be adjusted in future periods as market and competitive conditions change. Implementation of this strategy is expected to result in additional integration charges that will be reflected in Corporate reporting, and not included in the determination of Division income in future periods. 27-------------------------------------------------------------------------------- Table of Contents NORTH AMERICAN BUSINESS SOLUTIONS DIVISION Third Quarter Year-to-Date (In millions) 2014 2013 2014 2013 Sales $ 1,522 $ 811 $ 4,554 $ 2,408 % change 88 % (2 )% 89 % (2 )% Division operating income $ 67 $ 39 $ 165 $ 96 % of sales 4 % 5 % 4 % 4 % Sales in our North American Business Solutions Division increased 88% in the third quarter of 2014 compared to sales in the same period in the prior year, primarily as a result of the addition of OfficeMax 2014 sales of $686 million. Excluding the OfficeMax sales, third quarter 2014 sales would have increased 3%. As the integration of the two companies continues, the delineation of the contribution from the separate companies is diminishing. Sales under the Office Depot banner in the third quarter of 2014 compared to the same period in 2013 increased in the contract and direct channels. Sales increase in the North American Business Solutions Division include benefits from the integration as sales are recorded in the combined entity's systems and presented under the Office Depot banner. However, sales in the merged business in Canada have shown declines compared to earlier quarters of 2014, in part reflecting the closing of Grand & Toy stores during the second quarter of 2014. Online sales through the direct channel increased during the third quarter of 2014, reflecting efforts to enhance the Internet shopping offering and experience. The increased online sales were partially offset by reduced call center sales. We anticipate this shift in customer shopping preference will continue. On a product category basis under the Office Depot banner, sales increased across all categories. Division operating income for the third quarter of 2014 was $67 million, compared to $39 million in the same period of the prior year. Division operating income as a percentage of sales in the third quarter of 2014 decreased to 4% compared to 5% in the same period in 2013. Gross profit margin decreased reflecting in part the impact of adding OfficeMax contract channel customers with a higher mix of lower margin accounts. The Company will focus on improving the overall mix of customers and offering margin enhancing products and services to align more with the Office Depot contract channel customers. The gross profit margin decrease was offset by lower advertising and payroll expense as a percentage of sales across this Division compared to the prior year. These benefits reflect efficiencies of combining the companies. In year-to-date 2014, sales in our North American Business Solutions Division increased 89% compared to sales in the same period in the prior year, primarily as a result of the addition of OfficeMax 2014 sales of $2,128 million. Excluding the OfficeMax sales, year-to-date 2014 sales would have increased 1% compared to year-to-date 2013. The factors discussed impacting the third quarter of 2014 sales, gross profit, and advertising expenses are also reflective of those impacting year-to-date. In year-to-date 2014, the Company closed the 19 Grand & Toy stores in Canada that were added as part of the Merger. Because this decision was after the Merger date, the fair value of assets for these locations recognized in purchase accounting has been written down to the amount recoverable through operations. That impairment charge has been reflected in the Asset impairments line in the Condensed Consolidated Statement of Operations and as a Corporate charge, not included in determination of Division operating income. 28-------------------------------------------------------------------------------- Table of Contents INTERNATIONAL DIVISION Third Quarter Year-to-Date (In millions) 2014 2013 2014 2013 Sales $ 797 $ 680 $ 2,565 $ 2,137 % change 17 % (2 )% 20 % (4 )% Division operating income $ 10 $ 6 $ 25 $ 8 % of sales 1 % 1 % 1 % - % Sales in our International Division in U.S. dollars increased 17% in the third quarter of 2014 and 20% in year-to-date 2014, compared to sales in the same period in the prior year. The increases primarily result from the addition of OfficeMax sales of $127 million and $420 million for the third quarter and year-to-date 2014, respectively. Excluding the OfficeMax sales, third quarter and year-to-date 2014 sales compared to the same period last year would have decreased 1% in U.S. dollars in the third quarter of 2014 and remained constant in year-to-date 2014. On a constant currency basis, sales decreased 4% and 3% for the third quarter and year-to-date 2014, respectively. On a working day basis, sales under the Office Depot banner in the contract and direct channels decreased in both the third quarter and year-to-date 2014. The contract channel sales decline reflects competitive market pressures, the loss of certain contracts and discontinuation of low margin business. The sales decline in the direct channel reflects the continued decline in catalog and call center sales, partially offset by online sales increases. The Company continues to focus on improving the rate of decline in the direct channel. Division operating income totaled $10 million in the third quarter of 2014, compared to $6 million in the same period of 2013. Division operating income represents 1% of sales in both the third quarter of 2014 and 2013. Division operating income totaled $25 million in the year-to-date 2014, compared to $8 million in the same period of 2013. Division operating income increased to 1% of sales in year-to-date 2014 compared to zero in year-to-date 2013. The improvement in Division operating income reflects benefits from lower payroll and advertising, as well as benefits associated to prior restructuring activities under the Office Depot banner. The Company anticipates incurring incremental pre-tax restructuring expenses of approximately $120 million, through December 2015, to align the organization from a geographic-focus to a channel-focus. The expected $120 million will consist of severance pay, other employee termination benefits, costs associated with lease obligations, and other costs. Costs associated with restructuring activities are reported at the Corporate level and discussed in the "Restructuring and other operating expenses, net" section below. For U.S. reporting, the International Division's sales are translated into U.S. dollars at average exchange rates experienced during the period. The Division's reported sales were positively impacted by $13 million and $81 million from changes in foreign currency exchange rates in the third quarter and year-to-date 2014, respectively. Internally, we analyze our international operations in terms of local currency performance to allow focus on operating trends and results. 29 -------------------------------------------------------------------------------- Table of Contents OTHER 2014 (In millions) Third Quarter Year-to-Date Sales $ 28 $ 155 Other operating income $ 1 $ 8 With the Merger, we acquired the OfficeMax joint venture business operating in Mexico, Grupo OfficeMax. In August 2014, we completed the sale of our interest in this business to our joint venture partner. In the second quarter of 2014, due to the pending sale, the integration of this business into the International Division was suspended and has since been managed and reported independently of the Company's other international businesses. Prior period segment information has been recast to reflect this change in the reporting structure. Since the Company controlled the joint venture, the total Grupo OfficeMax results through the date of the sale are included in the Condensed Consolidated Statement of Operations, with an apportionment of the period results to the noncontrolling interest based on their ownership percentage. The assets and liabilities of the joint venture are presented in the Condensed Consolidated Balance Sheet at December 28, 2013, as Assets of consolidated joint venture held for sale and Liabilities of consolidated joint venture held for sale, respectively. The release of cumulative translation adjustments and transaction fees are included in Merger, restructuring and other operating expenses, net. The Company adopted the new accounting standard on discontinued operations in the second quarter of 2014. While this is a disposal of all operations in Mexico, it is not considered to have a major effect on our operations or financial results and, accordingly, it is not presented as discontinued operations. CORPORATE The line items in our Condensed Consolidated Statements of Operations impacted by Corporate activities are presented in the table below, followed by a narrative discussion of the significant matters. Third Quarter Year-to-Date (In millions) 2014 2013 2014 2013 Asset impairments $ 6 $ 49 $ 77 $ 58 Merger, restructuring, and other operating expenses, net 72 44 276 90 Legal accrual 1 - 81 - Total charges and credits impact on Operating income (loss) $ 79 $ 93 434 $ 148 In addition to these charges and credits, certain Selling, general and administrative expenses are not allocated to the Divisions and are managed at the Corporate level. Those expenses are addressed in the section "Unallocated Expenses" below. Legal Accrual In June 2014, the Company participated in a non-binding, voluntary mediation regarding the previously disclosed matter, State of California et al. ex. rel. David Sherwin v. Office Depot. The lawsuit sought claims based on allegations regarding certain pricing practices under now expired agreements that were in place between 2001 and January 1, 2011. In the mediation, the Company negotiated a potential settlement to resolve the matter. During 2014, the Company recorded an $81 million incremental increase to the legal accrual which included the potential settlement of approximately $68 million, as well as attorneys' fees and other related legal matters. The parties continue to work to finalize the settlement. A hearing to obtain final court approval for the settlement is scheduled for November 18, 2014. There can be no assurance that the court will approve the settlement on the hearing date. 30-------------------------------------------------------------------------------- Table of Contents Asset Impairments, Merger, Restructuring, Other Charges and Credits In recent years, we have taken actions to adapt to changing and competitive conditions. These actions include closing stores and distribution centers, consolidating functional activities, disposing of businesses and assets, and improving process efficiencies. We have also recognized significant asset impairment charges related to stores and intangible assets and significant expenses associated with the Merger and integration. These activities are managed at the Corporate level and, accordingly, are not included in the determination of Division income for management reporting or external disclosures. These expense items are expected to continue in future periods. Asset Impairments We recognized asset impairment charges of $6 million and $49 million in the third quarters of 2014 and 2013, respectively, and $77 million and $58 million in year-to-date 2014 and 2013, respectively. The 2014 year-to-date charges include a $28 million asset impairment related to the abandonment of a software implementation project in Europe, $25 million related to the write off of capitalized software following certain information technology platform decisions related to the Merger, as well as store impairments. The third quarter 2014 charge includes approximately $1 million impairment of favorable lease intangible asset values following identification of closing locations where future intangible asset recovery was considered unlikely. The third quarter and year-to-date 2013 impairment charge include $44 million goodwill impairment triggered by the sale of our interest in Office Depot de Mexico. Both periods in 2014 and 2013 include expenses related to underperforming stores in North America. The store impairment charges recognized in the third quarter and year-to-date 2014 were based on discounted cash flow analyses of the retail locations that assumed a sales decline the next year similar to recent experience, with negative but improving rates for later years. Gross margin assumptions and operating costs were assumed to be consistent with recent actual results and planned activities. Based on development of the real estate strategy during the second quarter of 2014, the Company currently anticipates closing at least 400 stores by the end of 2016, including approximately 165 stores in 2014. For purposes of the store impairment analysis for the third quarter of 2014, cash flow periods were limited to the likely closure dates identified in the analysis. Over this implementation horizon, the extent and identity of closures is likely to change based on market condition, competitive behavior, results experienced from closures compared to expectations, the real estate market and other factors. To the extent that future sales and operating assumptions in the current portfolio are not achieved or are subsequently reduced, or more or different stores are closed, additional impairment charges may result. Additionally, we may experience volatility from the timing of recognition of impairment charges followed by credits related to capital leases and deferred rent accounts if the leases are terminated or modified. However, at the end of the third quarter of 2014, the impairment analysis reflects the Company's best estimate of future performance, based on the current business model. Merger, restructuring and other operating expenses, net Merger We recognized Merger-related expenses of $55 million and $40 million in the third quarters of 2014 and 2013, respectively. In year-to-date 2014 and 2013, Merger-related expenses amounted to $242 million and $72 million, respectively. The $242 million incurred in 2014 includes (i) $136 million of employee related expenses for termination benefits and certain incentives to retain and motivate employees; (ii) $92 million related to transaction and integration activities, which were primarily integration-related professional fees, incremental contract labor, non-capitalizable software integration costs, and other direct costs to combine the companies; and (iii) $14 million of other expenses including accelerated depreciation, lease closure accruals and asset dispositions. Such costs in 2014 include both merger and integration expenses and costs incurred and accrued to date relating to implementation of the real estate strategy, other than asset impairments that are discussed above. Expenses in the 2013 periods were incurred by Office Depot prior to the Merger and include investment banking and professional fees associated with the transaction, including preparation for regulatory filings and shareholder approvals, as well employee retention accruals, direct incremental travel and dedicated personnel costs. It is expected that significant Merger-related expenses will continue to be incurred in future periods as decisions are made about facility closures, organizational structure and other integration activities. We estimate that merger and integration expenses will be $400 million during the three-year period of 2014 through 2016, excluding costs related to rationalizing and optimizing the U.S. retail store base and other asset impairments. We anticipate that approximately $300 million of these integration expenses will be incurred in 2014. In addition, for all store closures in 2014, we expect to accrue approximately $40 million for any remaining lease obligations, subject to mitigation through negotiations with landlords and in some cases subleasing, and additional other store closure costs. Refer to Notes 2 and 3 of the Notes to the Condensed Consolidated Financial Statements for additional information 31-------------------------------------------------------------------------------- Table of Contents Restructuring and other operating expenses We recognized restructuring and certain other operating expenses of $17 million and $4 million in the third quarters of 2014 and 2013, respectively. In year-to-date 2014 and 2013, restructuring and other operating expenses amounted to $34 million and $18 million, respectively. Restructuring and other operating expenses in all periods presented primarily related to severance and other costs for organizational changes in Europe. The expenses in year-to-date 2013 include a net benefit from an asset disposition in Europe that was more than offset by severance and other restructuring charges. In October, 2014, we approved the European restructuring plan to realign the organization from a geographic-focus to a business channel-focus. The restructuring plan includes the creation of centralized and standardized processes that operate across Europe and the elimination of approximately 1,100 employee positions. This excludes approximately 300 employee positions previously eliminated. As required by law, the Company is consulting with each of the affected countries' local Works Councils as part of the implementation of the restructuring plan, which is expected to be substantially completed by December 2015. We expect the restructuring to result in approximately $90 million of annual cost reduction benefits by the end of 2016. We anticipate incurring incremental pre-tax restructuring expenses of approximately $120 million, which consist of approximately $95 million of severance pay and other employee termination benefits and approximately $25 million of costs associated with lease obligations and other costs. Unallocated Expenses The Company allocates to the Divisions functional support costs that are considered to be directly or closely related to segment activity. Those allocated costs are included in the measurement of Division operating income. Other companies may charge more or less of functional support costs to their segments, and our results therefore may not be comparable to similarly titled measures used by other companies. The unallocated costs primarily consist of the buildings used for the Company's corporate headquarters and personnel not directly supporting the Divisions, including certain executive, finance, audit and similar functions. Following the Merger, unallocated costs also include certain pension expense or credit related to the frozen OfficeMax pension and other benefit plans. Unallocated expenses were $29 million and $19 million in the third quarters of 2014 and 2013, respectively. The increase primarily reflects $6 million from the addition of OfficeMax, as well as higher variable pay partially offset by lower functional area expenses not allocated to the Divisions. Unallocated expenses were $88 million and $60 million in year-to-date 2014 and 2013, respectively. The unallocated expense increase in year-to-date 2014 largely reflects the same factors as the increase experienced in the third quarter, with $22 million attributable to the addition of OfficeMax. Other Income and Expense Third Quarter Year-to-Date (In millions) 2014 2013 2014 2013 Interest income $ 6 $ 1 $ 18 $ 1 Interest expense (25 ) (15 ) (65 ) (48 ) Gain on disposition of joint venture - 381 - 382 Other income (expense), net 1 - (1 ) 14 Third quarter and year-to-date 2014 interest income includes $5 million and $16 million, respectively, of interest income earned on the OfficeMax Timber Notes net of amortization of the fair value adjustment recorded at the Merger date. The associated non-recourse debt net of amortization of the fair value adjustment recorded at the Merger date added $5 million and $15 million of interest expense in the third quarter and year-to-date 2014, respectively. Interest expense in the third quarter and year-to-date 2014 also reflects an additional $5 million and $15 million of increase, respectively, due to interest incurred on debt acquired in the Merger, offset by decreases of $1 million and $5 million, respectively, associated with the maturity of $150 million of the 6.25% senior notes in August 2013. Additionally, interest expense in year-to-date 2014 includes a $9 million reversal of previously accrued interest expense on uncertain tax positions following resolution of the related matter. In July 2013, the Company completed the sale of its investment in Office Depot de Mexico to Grupo Gigante, S.A.B. de C.V. for the Mexican Peso amount of 8,777 million in cash ($680 million at then-current exchange rates). A pretax gain of $381 million was recognized in the third quarter of 2013 ($382 million for the year-to-date period). The gain is net of third party fees, as well as recognition of $39 million of cumulative translation loss released from other comprehensive income because the subsidiary holding the investment was substantially liquidated. 32 -------------------------------------------------------------------------------- Table of Contents Other income (expense), net includes gains and losses related to foreign exchange transactions, losses on sales of the Boise Cascade Company stock received by the Company following the Merger, investment results from deferred compensation plans, and prior to the sale in July 2013, our portion of the Office Depot de Mexico joint venture income. The year-to-date 2013 include $13 million as our portion of joint venture earnings. Income Taxes In year-to-date 2014, the Company recognized income tax expense on a pretax loss resulting from deferred tax benefits not being recognized on pretax losses in certain tax jurisdictions with valuation allowances, while income tax expense was recognized in tax jurisdictions with pretax earnings. The decrease in income tax expense in the third quarter and year-to-date 2014 from the same periods of 2013 is primarily attributable to the 2013 sale of our investment in Office Depot de Mexico, which resulted in $146 million of income tax expense in the third quarter of 2013. The sale of the Company's interest in Grupo OfficeMax during 2014 did not generate a similar gain or tax expense. In addition, during the second quarter of 2014, we recognized $7 million of income tax benefits for the release of valuation allowance and favorable settlements with certain tax authorities, as described below. Following the recognition of significant valuation allowances in the U.S. and certain foreign jurisdictions in 2009, we have regularly experienced substantial volatility in our effective tax rate in interim periods and across years. Because deferred income tax benefits cannot be recognized in several jurisdictions, changes in the amount, mix, and timing of pretax earnings among jurisdictions can have a significant impact on the overall effective tax rate. This interim and full-year volatility is likely to continue in future periods until the valuation allowances can be released. The Company has significant deferred tax assets in the U.S. and in foreign jurisdictions against which valuation allowances have been established to reduce such deferred tax assets to the amount that is more likely than not to be realized. During the second quarter of 2014, the Company released valuation allowance in certain foreign jurisdictions due to the existence of sufficient positive evidence, which resulted in the recognition of a $4 million income tax benefit. As of the third quarter of 2014, valuation allowances remain in certain foreign jurisdictions where the Company believes it is necessary to see further positive evidence, such as sustained achievement of cumulative profits, before these valuation allowances can be released. If such positive evidence develops, the Company may release all or a portion of the remaining valuation allowances in these jurisdictions as early as the first half of 2015. Due to settlements with certain tax authorities in the second quarter 2014, the Company's balance of unrecognized tax benefits decreased by $3 million, which resulted in an income tax benefit of the same amount, in year-to-date 2014. The Company also estimates its unrecognized tax benefits to increase by $13 million in 2014 for current year positions in certain tax jurisdictions, only $1 million of which is estimated to increase income tax expense for the year due to valuation allowances. After application of interim period tax accounting, the Company's unrecognized tax benefits increased by $5 million and $9 million in the third quarter and year-to-date 2014, respectively. The remainder will be recognized in the fourth quarter of 2014. This increase resulted in $1 million of income tax expense in year-to-date 2014. Additionally, the Company anticipates that it is reasonably possible that new issues will be raised or resolved by tax authorities that may require changes to the balance of unrecognized tax benefits; however, an estimate of such changes cannot be reasonably made. Preferred Stock Dividends In connection with the Merger, in both July and November 2013, we redeemed 50 percent of the outstanding redeemable preferred stock. Preferred stock dividends included in the Condensed Consolidated Statement of Operations for the third quarter and year-to-date 2013 include contractual dividends and $22 million related to the July 2013 redemption, comprised of the $12 million redemption premium, measured at 6% of the liquidation preference, and $10 million representing 50 percent of the difference between the liquidation preference and carrying value of the preferred stock. The liquidation preference exceeded the carrying value because of initial issuance costs and prior period paid-in-kind dividends recorded at fair value. NEW ACCOUNTING STANDARDS In April 2014, the Financial Accounting Standards Board (the "FASB") issued an accounting standards update that changes the criteria for reporting discontinued operations. Under the new guidance, only disposals representing a strategic shift in operations that has (or will have) a major effect on an entity's operations and financial results will be presented as discontinued operations. The standard also removed continuing cash flows and significant continuing involvement as considerations in determining if a disposal should be presented as discontinued operations. The standard is to be applied prospectively and is effective for public entities beginning in annual periods after December 15, 2014, with early adoption allowed. The Company elected to adopt this standard early, which had no significant impact in the Company's Condensed Consolidated Financial Statements. 33 -------------------------------------------------------------------------------- Table of Contents LIQUIDITY AND CAPITAL RESOURCES At September 27, 2014, we had approximately $965 million in cash and equivalents and another $1.2 billion available under the Amended Credit Agreement (as defined in Note 5 of the Condensed Consolidated Financial Statements) based on the September borrowing base certificate, for a total liquidity of approximately $2.1 billion. We currently believe that our cash on hand, availability of funds under the Amended Credit Agreement, and cash flows generated from operations will be sufficient to fund our working capital, capital expenditure and debt repayment requirements for at least the next twelve months. At September 27, 2014, no amounts were drawn under the Amended Credit Agreement. There were letters of credit outstanding under the Amended Credit Agreement at the end of the second quarter totaling $92 million. We also had short-term borrowings of $1 million at September 27, 2014 under various local currency credit facilities for our international subsidiaries that had an effective interest rate at the end of the second quarter of approximately 4.9%. The maximum month end amount occurred in March at approximately $10 million and the maximum monthly average amount occurred in March at approximately $6 million. These short-term borrowings represent outstanding balances on uncommitted lines of credit, which do not contain financial covenants. The Company was in compliance with all applicable financial covenants at September 27, 2014. In year-to-date 2014, we incurred significant expenses associated with the Merger and integration actions, including costs associated with the real estate strategy, as well as restructuring expenses associated to actions taken in Europe. Significant Merger and restructuring expenses are expected to continue to be incurred in future periods. In connection with the European restructuring plan approved in October 2014, we anticipate incurring incremental pre-tax restructuring expenses of approximately $120 million, $112 million of which will result in cash expenditures during 2014 and 2015. We expect the restructuring plan to be substantially completed by December 2015. In connection with the Merger, we assumed obligations under the OfficeMax North American pension plans and other post-employment plans. In year-to-date 2014, $43 million of cash contributions were made to the North American pension and other post-employment plans. An additional $1 million cash contribution is expected to be made to these plans in 2014. The amounts funded are presented as Operating activity outflows in the Condensed Consolidated Statement of Cash Flows. Cash Flows On November 5, 2013, the Company merged with OfficeMax Incorporated. Accordingly, the Condensed Consolidated Statement of Cash Flows for year-to-date 2014 includes the OfficeMax results, with no comparable amounts in the year-to-date 2013. Cash provided by (used in) operating, investing and financing activities is summarized as follows: Year-to-Date (In millions) 2014 2013 Operating activities $ 35 $ (120 ) Investing activities 1 582 Financing activities (10 ) (410 ) Operating Activities During year-to-date 2014, cash provided by operating activities was $35 million, compared to a use of cash of $120 million during the same period last year. Operating cash flows in 2014 include approximately $234 million use of cash associated with Merger-related activities. Refer to Merger, restructuring and other operating expenses, net discussion above for anticipated future costs of integration activities. Operating cash flows in 2013 was negatively impacted by the payment of $147 million income taxes related to the Company's gain on disposition of the investment in Office Depot de Mexico. No similar gain or tax payment was recognized in 2014 relating to the disposition of the Company's interest in Grupo OfficeMax. Changes in net working capital and other components for year-to-date 2014 resulted in a $64 million use of cash compared to an $83 million use in the same period last year. The change reflects the timing of activity toward the end of the respective balance sheet periods, the impact of Merger activity, the legal accrual and the inclusion of OfficeMax in the 2014 results but not 2013. Working capital is influenced by a number of factors including the flow of goods, credit terms, timing of promotions, vendor production planning, new product introductions and working capital management. For our accounting policy on cash management, refer to Note 1 of the Condensed Consolidated Financial Statements. 34 -------------------------------------------------------------------------------- Table of Contents Investing Activities Cash provided by investing activities was $1 million in the year-to-date 2014, compared to a cash provided by investing activities of $582 million in the same period last year. The year-to-date 2014 includes $43 million net proceeds from the disposition of Grupo OfficeMax, $43 million proceeds from the disposition of Boise Cascade Company common stock received from the Boise Cascade Holdings distribution, offset by capital expenditures of $90 million. The 2014 period also includes $9 million from proceeds from assets sold and other. The $582 million cash generated in the 2013 period primarily relates to the $675 million proceeds from the disposition of our joint venture Office Depot de Mexico, partially offset by $94 million capital expenditures. Financing Activities Cash used in financing activities was $10 million in year-to-date 2014, compared to a cash use of $410 million in the same period last year. Net payment of long- and short-term borrowings amounted to $14 million in year-to-date 2014 compared to $17 million in the same period last year. In the third quarter 2013, the Company redeemed 50 percent of the preferred stock with a cash payment of $216 million. The redemption payment of $216 million includes the liquidation preference of $203 million, a redemption premium of $12 million, measured at 6% of the liquidation preference, and regular dividends accrued to the redemption date of $1 million. The $12 million redemption premium and $1 million of the regular dividends accrued to the redemption date are presented in Preferred stock dividends in the 2013 Condensed Consolidated Statement of Cash Flow. In August 2013, the Company repaid the $150 million of 6.25% senior notes at maturity. CRITICAL ACCOUNTING POLICIES Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these financial statements. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our 2013 Form 10-K, in Note 1 of the Notes to the Consolidated Financial Statements and the Critical Accounting Policies section of the Management's Discussion and Analysis of Financial Condition and Results of Operations. An update to the Critical Accounting Policies section is provided below. Goodwill - Goodwill associated with the Merger has been allocated to the reporting units for the purposes of the annual goodwill impairment test. The estimated fair value of each reporting unit exceeds its carrying value at the test date. The reporting unit of Australia and New Zealand, which was not combined with any existing Office Depot businesses, has an estimated fair value approximately 10% above its carrying value. Goodwill in that reporting unit is $15 million. The estimated fair value of this reporting unit includes projected cash outflows related to certain restructuring activities. Should these restructuring activities not result in the anticipated future period benefits, or if there is a downturn in performance, a potential future goodwill impairment could result. However, the Company believes, based on these projections, that there are no current indicators of impairment in this reporting unit. The estimated fair values of the other reporting units, which were combined with existing Office Depot businesses, were substantially in excess of their carrying values. 35 -------------------------------------------------------------------------------- Table of Contents |